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Outsourcing offers value for stockpickers

There is still value on offer in the outsourcing sector, but with margins under pressure and cash getting tight, it is very much a stockpicker's market.
May 9, 2013

The outsourcing sector has thrashed the wider market over the past 12 months after investors latched on to its excellent revenue visibility, dividend growth and cash generation. But it has undergone a generous rerating, too, and broker Investec now thinks multiples are beginning to look stretched. Having been positive on the outlook across the board a year ago, the winds of change are now blowing margins off course, so we've taken another look at what has become a true stockpicker's market.

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Outsourcing outperformance

While the FTSE 100 has risen an impressive 15 per cent in a year, the FTSE support services sub-sector has surged 36 per cent since May 2012. Back then, we selected 'Five cheap, rock-solid shares' for readers with buy recommendations on Babcock (BAB), G4S (GFS), Serco (SRP), Mears (MER) and Mitie (MTO), all of which have enjoyed solid gains. While we remain positive on the outlook for the first three, we have tempered our views or turned outright negative on the prospects for others.

Of course, the big names continue to offer strong defensive characteristics and debt is down across the sector. However, the latest round of results revealed growing pressure on profit margins and increased cash flow demands, as government contracts ask outsourcers to do more with less in order to meet austerity targets. Outsourcing has become far more competitive, too, and the contracts are being awarded lower returns and are more capital-intensive.

Indeed, Babcock growing its order pipeline from £14bn to £15.5bn and Capita (CPI) seeing an increase from £4.8bn to £5.2bn looks like a positive. However, when this work will finally come through and the quality of the margins on those contracts is unknown. And investor enthusiasm over growing order books should be tempered. In order to deliver the growth rates that the market expects, a pattern is emerging whereby outsourcers are migrating into new and unfamiliar areas and securing contracts that bring much higher levels of operational risk.

Under pressure

G4S's shares have just slumped after it admitted margins had slipped 60 basis points in the first quarter, with further weakness expected in the year ahead. G4S is not alone in feeling the pinch and companies are having to look further afield for growth. A recent joint venture contract announced by Capita and Staffordshire County Council to deliver support services to schools is a perfect example of this brave new world in outsourcing. The contract is worth £85m a year in revenue and, while there is little detail on the operating margin, it's unlikely to match the high double digits earned in the private sector. It will also need £24.9m in investment in the first year, and requires the transfer of some 3,800 council employees over to the joint venture vehicle. Capita looks to have its organic revenue growth targets of 6 per cent guaranteed, but these new contracts are straining margins and the forecast for 2013 has been cut by 70 basis points to between 13 per cent and 13.5 per cent. Transferring that many public sector employees increases operational risk, too.

Having delivered years of growth and returns for shareholders, Mitie is also migrating into new business areas to try to deliver the level of growth the market has come to expect. The acquisition of domiciliary care provider Enara for £111m takes Mitie away from its core business of looking after buildings, and into looking after people. It has made Mitie one of the top providers in a sector it thinks is worth £8bn, but there are concerns here - broker Peel Hunt, for example, fears they may have overpaid for a company that was itself a collection of private equity deals. Again, there is the increased operational risk of integrating a business in which Mitie has little experience. And analysts believe Mitie is finding the market for its core facilities management business - maintaining work canteens and keeping buildings and, more importantly, toilets clean and serviceable - increasingly crowded, which means it's having to promise bigger cost savings upfront in order to win contracts.

Mears, historically a provider of maintenance services for social housing clients, has also branched out into new markets with the £22.5m deal for homecare provider ILS. However, providing nursing care is a long way from fixing boilers and fitting double glazing and, like Mitie, Mears is finding its core markets increasingly tough. So far, it has benefited by taking out struggling competitors like Morrison, but even that deal is proving hard to digest - it pulled out of a contract worth £350m to provide services to Circle after admitting it couldn't make money under the terms Morrison had agreed.

 

IC VIEW:

When Prime Minister David Cameron promised to "open the door" of the public sector to private sector competition shortly after coming to office, the outlook for the industry improved. But the contracts were slow in coming and share prices didn't respond until early 2012. Investors Chronicle readers have enjoyed the rerating of our buy recommendations across the sector, but we now take a more cautious approach. The government also appears less sure-footed in the way it handles outsourcing, evidenced by delays in government decisions on Ministry of Justice contracts that were due at the end of last year. This puts a big question mark against the timing of those bulging bid pipelines.

 

Company nameTicker (p)Market Cap (£m)Price change last 12 months %Forward PEProspective Yield %Last IC View
G4SGFS260      3,651 -4.911.13.45Buy, 292p, 11 April 2013
MEARS GROUPMER344        339 31.512.32.32Hold, 374p, 19 March 2013
MITIE GROUPMTO269        996 -6.6611.43.64Sell, 294p, 14 March 2013
SERCO GROUPSRP613      3,062 11.4414.11.65Buy, 620p, 5 March 2013
CAPITACPI901      5,912 37.616.12.61Sell, 827p, 28 February 2013
BABCOCK INTL.BAB1071      3,878 30.615.62.18Hold, 1075p, 18 April 2013
Simple Average13.42.64
Source: Datastream